The three things spooking markets: rational or not?

Equities are being rattled by three fears that are leading to an overreaction in markets, says Robeco’s Lukas Daalder.

Lukas

Daalder

Former CIO Robeco Investment Solutions. Daalder left Robeco in July 2018.

Speed read

Chinese stock market woes should not affect Western equities

Lower oil price has many positives such as more spending power

High yield market does not really act as an economic barometer

Robeco Investment Solutions remains overweight equities

He says the meltdown in Chinese stocks has been combined with a perceived negative consequence of the continued fall in the oil price and a flawed belief that problems in the High Yield market are a barometer for global recession.

However, all three things have a limited bearing on true economic prospects and are simply causing overreactions, says Daalder, Chief Investment Officer of Robeco Investment Solutions. Subsequently, his team remains overweight on equities, believing they still have good prospects for 2016.

“The most obvious concern that has triggered the current risk-off environment is developments in China,” says Daalder. “We can understand that a 7% loss in China on the first trading day is a bit of a sentiment spoiler, and so the fact that stocks closed lower everywhere else was not a big surprise. We have a lot more trouble however in explaining why stocks continued to sell off on the China argument for the week as a whole.”

The Chinese stock market has long been considered to be a deflating bubble. Source: Bloomberg/Robeco.

“The Chinese stock market is a standalone creature that has a life of its own, rising by 150% in the 2014-2015 period, despite weakening earnings fundamentals. It represents a classic bubble, which is now in the process of being deflated. Unlike the US or European markets – which are much more intertwined – there are no direct spillover effects to the rest of the world. Chinese stocks are mostly owned by a fairly limited group of domestic investors, so the pain of the losses is not felt outside of China.”

“As for the devaluation of the yuan, the 1.5% move seen since the start of this year is neither shocking, nor will it have much of an impact. Even if we extend the period to August 2015, the total devaluation has reached 6%: the euro declined by that much in less than a month in October-November.”

A lower oil price has benefits

Daalder says the second irrational thing spooking markets is the lower oil price, and the belief that this indicates faltering demand, and therefore economic weakening. Sentiment has also been harmed by a diplomatic spat between two of the world’s largest oil producers, Saudi Arabia and Iran.

“Even if we could state that demand for oil is falling, it still does not mean that the world economy is weakening: extremely warm winter weather in the Western hemisphere (El Niño) or the structural shift to solar energy could also play a role,” says Daalder.

‘It is a pretty one-sided way of presenting the oil story’

“The pain runs broader though, with many of the major oil-producing countries and companies currently feeling the pinch. This can lead those countries or companies to liquidate part of their investment portfolio, adding to the selling pressures in the market.”

“At the same time, it is a pretty one-sided way of presenting the oil story. What is absent is the positive side of the demise of oil prices: a big cost reduction for both consumers and producers, leading to a rise in disposable income and improved margins respectively. So far, the financial markets seem to strictly look at the negative impact, while ignoring the underlying positive.”

High Yield’s ‘early warning’ signal

A third factor weighing on the markets has been a weakening High Yield market and the notion that this is some sort of industrial barometer, Daalder says. US High Yield spreads – the difference between their yields and those of super-safe government bonds – have widened since June 2014, ending 2015 with a negative 4.5% return, the first loss since 2007.

“A negative consequence connected to this is an assumption that the High Yield market gives an early warning signal for trouble ahead,” says Daalder. “The rationale is that we have never witnessed a negative year outside a recession year, implying that we are heading for a recession.”

“In fact, 1994 and 2002 were both negative years outside a recession year, and it is further questionable whether this notion would also hold in the current low yield environment. Yields have dropped across the whole fixed income spectrum, which means that the underlying buffer has been lowered. Statistically this should lead to more negative return years, no matter what the economy does.”

Portfolio considerations

So, has the market overreacted? “Unfortunately, it doesn’t take much to push stocks lower in the current environment of weakened sentiment , but the fate of developed stock markets is not determined in China, but in the US,” says Daalder.

“With the US consumer in good shape, we think it is highly unlikely that we are entering a recession in 2016. Because of this assessment we continue to hold on to our risk-on portfolio construction.”